Something has clearly changed in global financial markets in recent weeks. Not only have they been falling, but real world issues have begun to provide a negative impact. This sounds a strange statement. But it simply means that in the past, markets have seen “bad news” as being good news. They expected that it would force central banks to provide more stimulus, as the Boom/Gloom Index chart above shows:
- The first stimulus package in 2009 took the US S&P 500 Index up 61% between March 2009 – April 2010
- QE2 took it up 32% between June 2010 – April 2011: Twist took it up another 27% between Sept 2011 -Sept 2012
- Since then, an unbroken ride took it up 32% by July, as US, EU and Japanese central banks printed cash
The idea behind the stimulus programme was that creating a ‘wealth effect’ in financial markets would somehow lead to sustainable recovery in the real economy, as then Fed Chairman Ben Bernanke argued in 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion”
In this, the Fed abandoned its historical role, as described by an earlier Chairman, William McChesney that:
“The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting”
Unsurprisingly, given the demographic headwinds, the new stimulus policy hasn’t worked:
- Japan still has a demographic deficit due to its ageing population. It is about to go back into recession, and is already back in deflation
- The US, UK and EU – also following it into demographic deficit – are also close to deflation, due to the combination of falling commodity prices and China’s New Normal policies
- And the latest Atlanta Fed estimate for Q3 GDP growth is just 0.9%, whilst Friday’s jobs report highlighted the underlying fragility of the US economy with the participation rate back at 1977 levels
And interestingly, one Fed Governor, James Bullard, has broken ranks with his colleagues and argued publicly for higher interest rates saying:
“The Fed cannot permanently raise stock prices (and)…its inappropriate to react to financial market turmoil. Historically the Fed has not wanted to react to this type of stuff and has tried to lay out a policy that’s more based on growth and labor markets…There is a powerful case to be made that its time to normalise interest rates.”
This is where the sentiment reading from the Boom/Gloom Index tells a story. It peaked back in February, and its subsequent rallies have never managed to return to this level. In turn, the S&P 500 has since peaked, breaking down quite sharply since July for its biggest fall in points since 2011.
Bullard’s comments don’t, of course, mean that the Fed won’t change its mind again as it did in 2011. It is highly likely to panic once again if stock markets continue to fall, and introduce more stimulus as QE4. But for the moment, traders are in the uncomfortable position of not being quite sure that this will happen.
They also have to worry that even if the Fed does move to QE4, along with the EU and Japan, some big investors may take this as a sign of panic. After all, real world issues such as China’s change of direction, Europe’s refugee and debt crises, and Syria’s civil war, cannot be solved by printing money and keeping interest rates low. So maybe, just maybe, markets are about to have to relearn this fundamental fact of life.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 54%
Naphtha Europe, down 52%. “Traders expect the low freight rates that recently opened up the arbitrage window to Asia to continue at least until November”
Benzene Europe, down 62%. “There have been considerable volumes of naphtha exported out of the ARA region to Asia for arrival in November, which has helped support European pricing.”
PTA China, down 44%. “ The reduced supply from plant turnarounds has not bolstered PTA prices”
HDPE US export, down 36%. “International resin prices seem to have stabilised at the current lower levels.”
¥:$, down 17%
S&P 500 stock market index, unchanged
Increasing volatility in major Western financial markets suggests they are struggling to maintain their momentum.
It is certainly hard to be very optimistic about the outlook for the major Western stock markets this year. The reason is that investors are still failing to think about political risk. They continue to believe, as they did a year ago, that nothing else matters as long as central banks continue to hand out large amounts of free cash to support stock markets.
But that was then, and this is now. And in reality, political risk is rising all around the world. We are seeing it most obviously in Greece, but it is also becoming a bigger factor in the UK ahead of May’s General Election – where it still seems unlikely that any single party can gain a majority .
Developments in the markets themselves also create cause for concern. The US market is now close to its record level in terms of Nobel Prizewinner Robert Shiller’s valuation metrics. And it is already at a record level of margin debt.
The reason is that investors have convinced themselves that the US Federal Reserve, like the European Central Bank, the Bank of Japan and the Bank of England, will never let stock markets fall again, for fear of another 2008 crash.
Thus investors, and the media and commentators who support their needs, spend all their time worrying about when US interest rates might rise, and by how much. Vast forests have been destroyed to provide the paper on which these learned discussions can take place: vast banks of servers have been built to provide their electronic equivalent.
Yet how much power do central banks really have over the world economy? Does the ability to raise or lower interest rates really enable them to control the economic tide? If it did, why are bond markets now so convinced that deflation is on its way in many major economies?
We are also already seeing corporate earnings being badly hit by the collapse of oil prices and the surge in the US dollar. And I remain convinced, as I have argued since August, that these developments are only the first stages of the Great Unwinding of central bank stimulus policy.
Last month, as the chart of the IeC Boom/Gloom Index above shows, the S&P 500 (red line) lost ground for a second month, causing US investment magazine Barron’s to comment:
“Stocks suffered their second straight monthly decline, while government bonds soared as their yields fell to record lows. April may be the cruelest month to the poet, but U.S. equity investors are down some $1.1tn since the market’s peak on Dec. 29. That includes a loss of $600bn last week and $300bn Friday alone, as the equity market failed to get the typical end-of-month lift from big players’ trying to burnish their monthly results.”
And at the same time, the Index itself (blue column) is sliding slowly but surely into serious downturn territory.
The stock market used to be a good leading indicator for the economy. But that was before the central banks decided to manipulate it for their own purposes. As then US Federal Reserve Chairman boasted 3 years ago on launching their second round of money-printing:
“Policies have contributed to a stronger stock market just as they did in March 2009, when we did the last iteration of this. The S&P 500 is up 20%-plus and the Russell 2000, which is about small cap stocks, is up 30%-plus.”
Of course, the Fed launched their QE low-cost money policy with the best of intentions. They genuinely thought that a higher stock market would boost consumer spending by creating a new ‘wealth effect’, and that this would then encourage companies to invest in new capacity, thus boosting employment.
Unfortunately, the data shows that fewer Americans own stocks than own houses – only 52% versus 65%. So the impact of higher stock prices hasn’t actually helped to boost spending, particularly as real household incomes remain well below pre-Crisis levels.
Instead we have seen a growing divergence between the performance of the stock market and the wider economy – the opposite of the Fed’s intention.
So the question now is very simple. Will the economy suddenly start to respond to the Fed’s policy? That, of course, would be very welcome, if it happened. Or will the Great Unwinding now underway in oil and currency markets start to impact equity markets as well?
Worryingly, the IeC Boom/Gloom Index is giving us its own answer – and it is not positive. As the chart above shows:
- The S&P 500 Index has hit a record 2000 level for the first time (red line)
- But the Boom/Gloom Index of sentiment actually fell sharply (blue column)
- It is now bordering levels which have always seen stock market losses in the past
The chemical industry is also, of course, also a good leading indicator. It tends to pick up around 6 months before the wider economy, and to turn down in advance as well. And its Q2 downturn was a clear signal that H2 would be more difficult that expected.
Now the the Boom/Gloom Index is reinforcing that message. Both indicators may be wrong, and the stock market right. But the blog certainly wouldn’t plan ahead on that basis, if it was still running a major chemical business today.
US and UK policymakers have been more upbeat recently in claiming that ”the economy was turning a corner”. Although they have not yet gone as far as in September 2009, when the G20 issued a statement that began ”It worked!”, and claimed the recession was now over.
Helpfully, the IeC Boom/Gloom Index has again done its job in capturing this improved sentiment. As the chart shows, it has climbed steadily since January (blue column), whilst the US S&P 500 Index (red line) has made record highs thanks to the support of the various stimulus programmes (yellow arrows).
But sentiment can change very quickly, and can often be quite different from the fundamentals. This, after all, was the reason that the blog first introduced the Index back in June 2009. And although the Index has moved into positive territory, it is well below earlier peaks.
This mirrors Mario Draghi’s new caution as head of the European Central Bank (ECB) when warning ““I can’t share the enthusiasm” about budding growth in the euro zone. “These shoots are still very, very green.”
One very senior executive certainly shared this caution when talking to the blog this week. He suggested his network of business partners were united in feeling conditions were going backwards, not forwards. This confirms the blog’s own sense that the global economy is at yet another crossroads.
The key question is simple: Are policymakers and the markets correct in their belief that the problems are now behind us? Or do we need more evidence before opening the champagne?
The key will likely be the impact of today’s much higher interest rates on the real economy. If these have no impact on demand, then we can assume that markets have done a good job in being forward-thinking with their optimism.
But if, as the blog fears, the recent summer-long party is followed by a cold winter, then today’s financial market celebrations may well look premature.
Financial markets cannot make up their minds about the outlook. As this month’s IeC Boom/Gloom Index shows, sentiment (blue column) remains exactly at the dividing line between optimism and pessimism.
This parallels the behaviour of the S&P 500 Index (red line). It had recovered strongly from March 2009, but has since found it very difficult to break through the 1370 level (thin red line):
• It peaked at this level in April 2011
• It broke though briefly in March/April this year, but then slipped
• It is now making its 3rd attempt
There is nothing ‘magic’ about the 1370 level. In good times, markets trade on fundamentals and will move forward if companies seem confident and earnings forecasts are positive.
But these are not good times. Markets are being kept alive by liquidity injections from central banks in the form of quantitative easing (QE). They rally, as last month, when these QE programmes are extended.
But successful traders are not stupid. They know that today’s economy is very fragile. So they are very careful about how they place their bets. 1370 has been the top of the range for some time, so they will be wary about becoming too optimistic.
Of course, the central banks may be right, and the blog wrong. Perhaps these latest QE efforts will succeed, where all the others have failed.
But the Boom/Gloom Index suggests caution remains the operative word.
The blog’s Boom/Gloom Index (blue column) reaches its 3rd anniversary this month.
It was introduced to help monitor sentiment in financial markets, on the basis that “many markets are clearly being ruled by sentiment”. It has since done a good job in identifying peaks and troughs:
• Peaks have been focused on periods when central banks have rushed to provide liquidity via quantitative easing and other stimulus programmes
• Thus the Index was strong from June 2009-June 2010, and from September 2010-June 2011
• The main trough has been seen since August 2011. This highlights the key flaw in the central banks’ thinking
• Their Quantitative Easing and bank lending programmes wrongly assume that markets face liquidity problems, rather than solvency risks
The Austerity measure (red line) in the chart highlights this issue. It shows how governments are increasingly being forced to abandon stimulus programmes, due to lack of cash. Investors increasingly worry that countries such as the PIIGS (Portugal, Ireland, Italy, Greece, Spain) will never repay their debts.
Thus June sees a sharp jump in the Austerity reading, back to levels last seen in May/June 2010 when the Eurozone crisis first properly erupted. In turn, this has pushed the Index below its neutral 4.0 reading and back into Gloom territory.
This highlights how the stimulus policies have been able to create short-term economic growth and major asset bubbles (oil/commodities prices, China real estate etc). But they have not created the conditions for sustainable long-term expansion.